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Mind the GAAP

February 17, 2016

By: Mat Lystra, Sr Research Analyst

I picked up the Sunday edition of The New York Times a few weeks ago and noticed a story about a well-known pharmaceutical company. It wasn’t the mention of the company itself that induced my read, but the story’s overarching caution about the use of non-GAAP earnings.[1] In particular, adjusted earnings were the subject of the article, which left me curious about how they might be affecting the membership of the Russell 1000 Index. When I took a closer look, I discovered that using adjusted earnings can indeed have a material impact on the earnings profiles of index constituents.

In the world of indexing we have historically tended not to worry so much about the earnings of individual companies and concerned ourselves more with market capitalization, liquidity, free float, etc. The use of fundamental financial measures is growing, however, as in the proliferating number of “fundamentally weighted” smart beta indexes or the use of medium term IBES earnings growth forecast when determining style (growth and value companies), and EPS variability when determining stability (defensive and dynamic companies).[2]

Earnings generally come in one of three forms: 1) reported earnings, 2) analyst forecasted earnings, and 3) adjusted earnings. The first two underlie the inputs used by FTSE Russell indexes for the purposes of index creation. But again, the third type – adjusted earnings – was the subject of The New York Times article.

Companies may have legitimate reasons for using adjusted figures like EBITDA (earnings before interest, taxes, depreciation and amortization) when a substantial non-recurring charge impairs the reported earnings.[3] But according to The New York Times, the pharma company’s adjusted earnings appeared to be used to systematically overstate the company’s earnings. There are few rules governing what can and can’t be left out of a company’s adjusted earnings and that flexibility gives U.S. companies plenty of room to get creative.[4]

So how are adjusted earnings impacting the membership of the Russell 1000® Index? In 2014 companies in the Russell 1000 had reported earnings of approximately $840 billion but adjusted earnings of nearly $2 trillion – $1.1 trillion gained from taxes and other write offs.[5] Additionally, I took a look at the 2014 fiscal year reported EPS (earnings per share), IBES 1yr forecasted EPS, and EBITDA per share for companies in the Russell 1000 Index.[6] The chart below plots Russell 1000 Index companies’ reported EPS and IBES analyst forecasted EPS – sorted in ascending order – along the horizontal axis, and the corresponding EBITDA per share along the vertical axis. The resulting positive slopes of our two clusters show how using adjusted earnings figures can dramatically impact the earnings profiles of companies in the Russell 1000 Index.

Such an outcome is not surprising – EBITDA by definition should produce a larger result – but as the practice of promoting adjusted earnings becomes commonplace and the race for informational advantage reaches lightning speed, distinguishing GAAP from non-GAAP may get lost as happened with the pharma company in the article.[7]

The same caution applies to index providers as we increasingly rely on fundamental financial measures of corporate performance to satisfy the demand for style, stability and smart beta. These are complex issues but as market participants place increasing weight on a range of underlying company performance data, the best index providers are thinking carefully about how accounting rules can affect outcomes. In other words, we have to mind the GAAP.

Russell 1000 companies look more profitable when using adjusted earnings per share.

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